When I taught economics, I always told my students that technology was important but also was known.  It was up to the economist to determine the most optimal allocation of resources given the prevailing technology.  OK, we also discussed the optimal exploitation of productive knowledge over time.  But we always waited until Newton developed his insights after the apple fell on his head.  We never wondered about when apples would fall, whether a Newton would be hit, and how he would react. 

Of course, future technology is not known.  What is known is the economic results of exploiting prevailing technology.  However, we cannot even say whether the current exploitation is optimal.  Nevertheless, those in the technology arena can learn something from economists, even as we await the results generated by technologists (a much better word than geeks). 

We know we are in the midst of a major technology wave.  Economists are debating whether this wave began in 1991, 1995 or soon thereafter.  We know, however, that adjusted for normal cyclical changes in productivity, a fundamental improvement in output from prevailing resources began developing sometime in the 1990s. 

In the previous two decades, output per unit of input grew less than a percent per year.  Since the mid 1990s, productivity gains have been more than 3 percent per year.  Indeed, some of the strongest productivity gains occurred early in the decade, when many production processes did not have sufficient quantities demanded to run at optimum rates. 

One explanation for this surge is simple:  we exported the use of hands.  Then we exported the rote mind activity, even to the point of sending code writing, form filling, and simple diagnostic readings abroad.  Even simple reporting (putting press releases into the available space) is likely to have a Bangalore byline.  As an economist, I know that such exporting will continue until the earnings abroad are sufficient to overcome barriers to travel here (some constraints, such as transfer costs, must keep qualified people from traveling to the higher paying country).  Brilliant politicians, if you erect immigration barriers, more jobs will be exported to overcome the inability to have the human capital migrate here. 

A second explanation is semiconductor technology and its adaptation to widespread uses.  Apparently, this continued improvement in processing and reduced size has not yet hit a barrier, though we are slicing the wafers almost atom width thin. 

A third is the improved processes used for economic transactions.  We call this the “back office” enhancements.  Is the revolution over here and now we are looking at the slower evolution as better processes are developed?

A fourth is related to the genome and the explosion of pharmacare.  In 2005, fewer U.S. inhabitants died than the year before.  Except for years following a death surge, such as the Spanish flu almost a century ago, this does not happen.  Yet, heart disease deaths are declining while many cancer deaths are leveling off.  And this is despite evidence that individual preventive activity, such as weight control and exercise, is decreasing on average. 

I am sure other explanations can be added to the list.  I would view internet communications as a cost reduction, but it clearly allows innovation.  Will we need movie theaters when we can have home theaters allowing rapid downloading and viewing of content on demand?

In Atlanta, communications and software were the recipients of venture capital when the internet bubble was about to burst.  Some of that communications hardware clearly was becoming obsolete.  Can you remember when the Norcross plant of AT & T produced the most fiber optic cable in the world?  That was less than a decade ago. 

Because venture capitalists thought communications along with internet retailing would be the next big things (and Atlanta did not finance much of the latter), Atlanta received a lot of capital to develop new ventures.  Of course, internet retailing struggled once the catalogs were digitized.  Amazon was able to exploit book and then some other inventories.  Ebay, with the aid of digital photography, offered every household the opportunity to become a retailer.  However, except for price discovery (who would again fall for those overstated auto prices from sales personnel once they visited Edmunds, for example) and some inventory management, the retailing did not displace brick and mortar. 

Although some claim that venture financing is back, much of the new funding is the result of a few large successes that reliquified the venture community.  To a large extent, these gains were concentrated in California, though some Boston, Dallas, and DC funding also surfaced.  From the fourth highest recipient of venture funds in 2001, Georgia has fallen out of the top ten today.  Our communications efforts have not been very profitable.  We are developing medical implements and have always done well with transactions processes, whether medical or financial.  Interesting work is developing in some of our universities, although the most successful university venture so far is golf grass. 

This absence of financing is unrelated to the absence of talent.  Recent studies indicate that Atlanta is one of the premier destinations for young professionals.  Because of the concentration of universities, Atlanta is ranked among the most literature populations of any major U.S. city.  Indeed, entrepreneurship remains significant, as more Atlantans per 100,000 population started businesses than in any other major city.  Yet, the financing for these entrepreneurs remains anemic. 

Whether Atlanta will have the successes that will attract sufficient venture capital to cultivate our talent remains to be seen.  If not cultivated here, that talent will drift elsewhere. 

In the meantime, I am wondering whether the latest technology wave has crested.  Productivity gains remain good (2.1% in the past year), but they definitely are slowing.  Could this be a normal cyclical slowing related to learning the capabilities of current capital before adding more?  Or have the best uses of the current technology already been identified, if not yet fully exploited?

I remain skeptical.  The returns created by additions to capital have rarely been higher.  For the entire economy, and this includes decaying industries and resource based activity where productivity is partially decaying over time, returns on new capital are well over 10 percent.  Those efficiently adding to their capital may be achieving more than 15 or even 20%.  At the same time, investors are willing to accept very low returns for risk. 

I cannot say who without analyzing individual companies, but I can say that such high returns in an era where investors are not demanding that much for risk (except in their choice of whether to provide funding at all) need to be more fully exploited.  This means that capital budgets should be expanding, not slowing, as they did in the past two quarters.  Do the CIOs know what their capital is returning and how to garner resources to add to profitability?  Are the CEOs aware of how high the returns on capital currently are?  Now those are questions upon which an economist can work. 

On the G-8 agenda in Scotland is how the developed world should deal with the massive poverty in
Africa.  Debt forgiveness is high on the list. 

Simultaneously, musical artists have been holding concerts to encourage that something be done in
Africa.  Why should so many starve when so many others have so much, they say?

First, the good news.  Despite a billion increase in the world’s population in the past ten years (that is not the good news), the number of people in poverty has actually declined.

The bad news is that almost all the decline in poverty has occurred in Asia and portions of
Latin America.  The starvation economies of
Africa have hardly been impacted. 

For years, economic development experts have been debating how to launch countries into the market economy and sustainable economic growth.  One group has argued that increasing the skills of workers through training and education will do the trick.  Another maintains that developing infrastructure, such as roads, storage systems, communications, and utilities will solve the problem. 

Others say, as the G-8 agenda implies, that lifting economic burdens will allow impoverished countries to rise.  Debt has been forgiven for some countries as much as 8 times since World War II with no appreciable change in their poverty levels.  That fact belies the last claim. 

Indeed, others have claimed that with debt forgiveness as the most common response, foolish resource allocation for the enhancement of those in power is actually encouraged.  If you know you eventually will not pay back the resources you borrowed, you become less careful about why and how you borrow.

I am not an economic development economist.  However, I must observe economic behavior to determine how markets are performing and how effective policies are. 

Vietnam can produce fiber products at half the price of northern China (who can produce such products 30 percent less than in Hong Kong and
Guangdong province).  Yet, much of our fiber product imports are coming from Hong Kong and only recently from northern
China.  Very little is coming from
Vietnam at this time.  Why?

Part of the answer is physical infrastructure.  Storage and transportation systems have just recently been  developed in northern China and have not yet been created in vast parts of
Vietnam.  However, a larger part is political infrastructure. 

Until recently,
Hong Kong was considered the most market friendly place in the world.  Property rights were sacred.  Contracts were rarely overturned.  Liability was limited to the economic entity, not its owners.  And courts would uphold these rights.  Capital was readily available and currency exchanges were easy with predictable values. 

Some of that has eroded as the Chinese central government has intensified its political hold on the former colony.  Nevertheless, enough political infrastructure exists there and in other parts of
China to make investment decisions viable throughout that country.  And now some of the needed physical infrastructure is being developed. 

By contrast, government is imposed upon many African peoples, some of whom are more attuned to their tribes across borders than to the governments within their borders.  For many, their governments do not speak for them.

With little capacity to alter power, many Africans do not accept the existing power.  Businesses usually seek local support and try to build their own protected structure.  To some extent, it is economic power created by businesses to exploit what cannot be accomplished elsewhere (otherwise they would not exert the costs needed to prosper in
Africa) against government power that has little popular support. 

Corruption is widespread, many government decisions are capricious, and many businesses have their own militias (or buy off those who otherwise threaten them). 

Of course, the debts of the past must be forgiven, if for no other reason than they cannot be paid off.  However, we would do more for the poverty stricken in
Africa if we encouraged the enfranchisement of local areas who could then share power to develop countries that can support laws and establish property rights. 

I do not know how to build the political infrastructure needed to start the march up from poverty in
Africa.  But I sense that any lasting improvement must begin with that political infrastructure first. 

An old joke talks about two hunters who can hear the lion prowling outside the light of their camp fire.  One quickly changes to track shoes.  The other says, “you cannot outrun a lion.”  The newly shod fellow replies, “no, but I can outrun you.”

Unless something changes very rapidly, the United States will run a $150 billion trade deficit with
China this year.  As startling as it seems, Japan’s trade deficit is only a tenth of that amount while their sales to
China are nearing three times ours.  Why can we not outsell Japan in
China?

Those who believe the differences are cultural do not know anything about Chinese history in the past century or so.  The U.S. sent gunboats up the
Yellow River before the Boxer rebellion, just as many other Europeans did. 

However, the other Western powers took the monetary ransom demanded from the Empress Dowager and built foreign concessions in
China where Chinese law was not allowed.  The
U.S. sent its share to the provinces to build schools for the missionaries who were trying to convert but also aid the village people. 

Chongqing has a museum honoring U.S. General Joseph Stillwell and his aviators.  At the same time Chinese demonstrators are complaining that Japanese history books are overlooking Japanese atrocities at
Nanking and elsewhere. 

Everything else being equal, the Chinese would rather deal with Americans than Japanese.  So why do the Japanese have the track shoes while the
U.S. is being devoured by Chinese exports?

To some extent, the Japanese are doing in China what the
U.S. has done so successfully so many other places around the world.  They are building partnerships with Chinese entrepreneurs.  

If you control the financial capital or brand, you control the flow of capital expenditures, most of which are not built in
China. 

While the U.S. is complaining about unfair trade and inappropriate currency values, the Japanese (along with the next largest international investor in China, the Taiwanese) are building factories in
China and buying their materials and equipment from Japanese suppliers.  Indeed, the Asians are constructing trading relationships that rival the European Union (although an Asian common currency is only partially valid, as many countries seek currency balance relative to the dollar.)

The
U.S. could be a player in that trading partnership.  However, our industry has become timid in competing in
China.  We believe that because the Chinese can produce good consumer products more cheaply than the U.S. can,
China might also produce our capital goods more cheaply as well. 

What is being missed is the size of the Chinese economy.  Capital expenditures in China are a quarter of the capital created in the
U.S. each year. 
China simply does not have the capacity to make our shirts, build our electronics, construct our planes, and build our power turbines at the same time.  They must choose how to use their limited resources. 

When they have spent the surpluses earned by selling goods to the U.S., China has bought the road machinery of South Korea, the electronics of Taiwan, the factory equipment of
Japan.  From the
U.S. the Chinese are buying higher education and beginning to purchase the expertise of industries such as appliance maker Maytag and now the bid for Unocal.

If we do not sell the products of our expertise to China,
China will buy or learn the expertise from us. 

At this point, with China remaining a much smaller economy than the U.S., our companies have a great opportunity to replace Japan as the major direct investor in
China. 

However, this opportunity will not remain indefinitely.  As
China’s economy continues to grow, its ability to finance its own capital expenditures will also increase.  If the Chinese economy has not become interrelated with U.S. technology and service skills before China no longer needs us, the American era truly will end in this century. 

This past week, the central banks of
Sweden and Hungry cut their interest rates.  Two members of the nine member board of the Bank of England also voted to cut their rates.  Rumors that the European Central Bank also is contemplating a rate reduction abound.  And a prominent bond investment manager has suggested that rate increases will shift to rate cuts before Alan Greenspan steps down early next year. 

Frankly, that last possibility is a Bill Gross exaggeration.  The likelihood that Greenspan would admit that rates were pushed too far by cutting them before he leaves, is lower than nil.  Nevertheless, bond investors want to believe that declining rates are the most likely outcome in the next six to twelve months. 

Part of the belief rests upon the extent of the “soft patch” that showed up in manufacturing in recent months.  Most economists were not surprised that the end of fiber quotas would create a flood of imports that overwhelmed domestic production.  Economists also realized that inventories grew too rapidly during the winter and would need to be reduced in the spring. 

In short, sluggish manufacturing should have been expected in the spring.  Also, the inventory correction suggests strength rather than weakness later in the year.

After a modest lull, diesel consumption is 6.9 percent above last year levels.  For the most part, this reflects the movement of goods, and the growth is higher than it was a year ago.  Housing activity remains stronger than projected while consumer spending has again spurted following a spring lull. 

If there was a “soft patch”, and the evidence is unclear on that, it certainly is over.  Except for a puzzling weakness in the leading indicators, little evidence of a need for lower interest rates exists in the
U.S. 

The remainder of the world may be another story. 

Parts of
Asia are doing as well as last year.  The latest Chinese production gains are 16 percent and consumption growth also is in double digits. 
Japan is performing better than expected, and their banks appear to have finally overcome the bad debt problems that have plagued them since the Nikkei and real estate bubble burst in 1988. 

A few soft patches have appeared in the Asian Tigers, such as Singapore, South Korea and
Taiwan.  However,
India still is gaining by more than 6 percent.  Overall,
Asia should grow about the same this year as last year, although some soft patches exist. 

If the Latin American closed end funds mean anything,
South America may be growing faster this year than last year.  Mexico might be having some problems and
Canada clearly is struggling to repeat last year’s more than 4 percent growth.  Nevertheless, the
Americas are doing their fair share. 

Unfortunately, except for the production of oil,
Africa hardly registers on the world economic scales.  However, oil production is up.

So the concerns about a slowing are centered in
Europe.  Eastern Europe shows moderate growth, though activity could quickly slump if
Western Europe falls into recession.  Clearly, the rumors and actions of central banks show that recession fears are growing.  Are they justified?

Unfortunately, the answer is yes.  Monetary policy has never been rearmed.  Because banks have been accommodative while economies were growing, central bank policy has limited capacity to stem any developing decline.  Nevertheless, some efforts will be exerted as unemployment rates jump to the teens. 

Budgetary policy, with a few exceptions, also has been relatively accommodating.  Deficits are large because of massive transfer programs from productive sectors to retirees, farmers, and even some workers in declining sectors.   Modest regulatory reforms have occurred, especially in Britain and
France, but the efforts remain small. 

Now,
Western Europe is being besieged by falling currency values and rising oil prices.  The former may aid the competitiveness of export industries (and most European countries continue to record trade surpluses despite lost markets to Chinese producers).  However, weak currencies enhance the jump in oil prices, which are priced in U.S. dollars. 

High unemployment and high energy costs are twin economic devils that may very well push
Europe into recession before the end of this year. 

In past world downturns, a weak
Europe meant a weak world economy.  Perhaps this time will be different, but investors certainly are not betting on that. 

The good news is that inflation vanished in May according to both the producers’ and consumers’ price indices.  The bad news is that the good news already is over. 

A drop in energy and food prices (mostly dairy and fruit prices) led to a substantial decline in the producers’ price index in May.  After those items were stripped away, prices grew a scant 0.1 percent at the finished goods level. 

At earlier stages of processing, the inflation performance was even more favorable.  Intermediate goods experienced a 0.3 percent price decline without food and energy while crude materials.  A component of my inflation indicators, crude materials other than food and energy, fell 3.6 percent following two small monthly increases. 

The less volatile consumer prices were not that encouraging.  In the past year, core inflation (prices less food and energy) rose 2.2 percent.  They did the same in the past three months. 

Before cheering price stability several items need to be noted. 

Of course, the most important one is energy.  Prices will rise about as much in June as they fell in May assuming no further oil price gains for the remainder of this month.  Energy price gains do not directly impact the core prices I was discussing above.  However, all goods are shipped somewhere and many require processing that uses energy.  Therefore, those declining core prices at earlier stages of processing in May do not mean finished goods prices will be falling in June or beyond. 

Also, 32 percent of the consumer price index is the cost of shelter.  A sharp decline in average daily room rates for lodging accounted for no change in that index both in April and May.  I have been tracking lodging rents every week for several years and acknowledge that those rates dipped in the early spring.  In the latest week, room rates were back to their 5 percent gains from previous year rates that they had established earlier in the year. 

In short, look for lodging rents to rise in June, taking away that very favorable core inflation performance. 

On the other hand (I am an economist), the GM auto discounts are not reflected in the May pricing report.  They will hold down auto prices in June.  By then, the discounting of women’s apparel following the spring fling in fashions will be over.  Also, a larger than normal price reduction for computers may not be repeated. 

However, those last components of the price index always are fluctuating with little trend over time (except for the monthly percentage point drop in computer prices).  The 5 percent recent trend growth in medicine and its services is intact while the nearly 7 percent annual tuition increase is lumped in with the falling computer prices. 

I certainly could again wonder how consumers are only using 4.6 percent of their budgets for medical care services when medicine is now 14 percent of our economy.  (Yes, governments and employers pay the rest.  Furthermore, the consumer’s co-pay adjustments are not considered as an increase in household medical costs, which dramatically distorts the purchasing power of households over time.)

So what should we take away from all these May inflation numbers?

First, they are favorable.  Even if most of the relief was at the gas pump, more jingle was left in the pocket to purchase something else.  Expect to see a solid rebound in retail sales in the next few months. 

Second, the favorable gains are fleeting.  Gasoline prices again are rising and may not dip again until after Labor Day.  If consumers reduce their conversion of home equity into consumer goods, they will not have enough jingle to preserve current strong spending growth through the remainder of this year. 

Third, some core measures are above the 2 percent price target that the Fed is rumored to desire for our economy.  This means their work is not yet done. 

Fourth, even with higher energy prices this year than last year, core inflation is not intensifying.  Thus, the Fed does not need to quicken its pace to get to its overnight interest rate destination.  Moreover, that destination may not be too far away.  (4 to 4.25 percent according to my reckoning.)

Fifth, if inflation is to be fundamentally lowered, we need to address specific sectors, such as medical services and education, to find out why price relief is so difficult there. 

Sixth, while the inflation indicators are our best estimators of overall price change, they need serious adjustments, especially in the medical and homeownership areas. 

In the meantime, let’s enjoy the good inflation news for May.  It will not be followed by more good news in June. 

As far as I can fathom, there are three explanations for the apparent “conundrum” that Fed Chairman Alan Greenspan continues to address. 

The conundrum is that yields on ten year government bonds are lower today than they were when the Federal Reserve began raising their interest rate targets from 1 percent about a year ago.  Normally, such as in 1994, the initial increase in short term rates leads to higher long term rates as well.  Some rise in long term rates initially happened but then rates settled back to less than 4 percent yields. 

Explanation one is that the Fed has achieved balance in the bond market and no longer needs to raise short term rates.  A realization that no further gains in short rates, if it is correct policy, would establish the normal 0.9 to 1.2 percentage point gap between overnight and 10 year money that investors normally believe to be necessary to compensate for risks of rate fluctuations over a ten year period. 

While some TV analysts are making the above case, it almost certainly is not correct.  Even Dallas Fed President Dick Fisher expects at least one more increase in short term rates.  That would provide only about a 0.65 percentage point compensation for the market risk faced by investors over ten years.  Historically, that is not enough. 

Furthermore, economists and futures markets for federal funds all believe that a minimum of 3.5 percent rates will be reached for overnight money.  This is inconsistent with 10 year yields below 4 percent when bond markets are in balance. 

Explanation two is that the Fed will push until a recession is inevitable in the next few years.  Then rates will need to be cut sharply again to restore economic growth.  Over the next ten years, that would mean a period of low overnight rates can again be expected despite the current increase in those very rates. 

A ten year bond with the same credit risk should provide a yield equivalent to all the overnight rates expected over those ten years (along with an insurance premium for forecast error, which is the reason for the additional yield).  So, investors may be forecasting significant weakness, requiring Fed intervention with lower rates in the not too distant future.

Wall Street analysts have discovered that higher short term rates than long term rates almost always predicts a recession ahead (about 11 to 18 months ahead).  We do not yet have such a condition, but further increases in short term rates could bring that about. 

I will not deny that a recession is possible if the Fed persists in raising short term rates.  However, if such weakness occurs, I think it already is baked in the cake without further Fed action.  Just as the bursting of the internet bubble led to a recession, the bursting of a real estate bubble could do the same. 

The conundrum is that if the Fed does not raise rates, the bubble will grow until it bursts on its own, much as the speculation in
Japan did in the latter 1980s.  If the Fed raises rates to starve the bubble, the higher rates could cause recession (though not as severe as the one that happens if the bubble bursts).  Could the Fed already be faced with the undesirable choice of staging a mild recession to avoid a substantial one?

Clearly, long term bond investors think the recession prospects no longer are minor. 

Explanation three is that the world has so much liquidity that Fed action to exhaust that liquidity will not be very successful.  The European Central Bank has been holding rates down regardless of economic growth in
Europe.  They now are confronted with economic slowing amid little ability to use stimulative monetary policy, because they never removed such accommodation. 

Because economic growth looks less appetizing in Europe, monetary accommodation is flowing to China and then to the
United States.  As I have mentioned in previous columns, those world nations that are running large trade surpluses have a more than normal desire to hold 10 year U.S. government bonds. 

I think reality is a little bit of explanation two and a great deal of explanation three.  If so, the Fed should continue to establish neutrality in overnight bond rates, even if those rates jump above the 10 year yield.  If this creates recession, then recession probably cannot be avoided.  To follow an alternative policy could create an even greater fallout when rising housing equity that is feeding consumption eventually stops, as it surely will.

What does the vote against the constitution of the European Union mean to
Europe and to the rest of the world?

In one sense, little has changed.  The French people have showed their ire toward their current government. The French electorate also indicated that they did not like the reduced economic and political role that
France would play in the New Europe.

Attempts to modify the constitution and still coax a favorable outcome in some western European countries certainly will follow. 

In the meantime, more countries will come under the umbrella of the confederation of European states called the European Union.  Those countries will have a common monetary policy, many common regulations, and increased flows of goods, services, and European tourists across borders. 

Apparently, that is all that the majority of Europeans want. 

Unfortunately, their current system soon will not be able to give them even that. 

As more countries with substantially different legacy costs, technology, and skills are introduced to the confederation, pressures will rise. 

Already, most of the western countries are struggling to keep their deficits within EU guidelines even as their unemployment rates rise to levels not seen since the Great Depression.  The lower income people in those countries are convinced that even lower wages in the new members will put them out of work. 

In fact, the high payroll costs make the hiring of new workers a risky business in
Western Europe.  Furthermore, unemployment payments that go on for up to two years reduce the speed with which the unemployed adjust to new opportunities. 

In some countries, board positions are held by union members, making cost cutting a very difficult process to approve.  Not surprisingly, companies in those countries are only considering expansion outside their countries. 

When Eastern European countries and Turkey join the Union, their lower cost labor will attract old
Europe capital.  To be sure, common regulations and ease of travel will aid the expansion to those new countries.  Undoubtedly, the unemployed, who are at double digit percentages in several European countries, will blame the new members for inflicting job losses on them. 

Certainly, we blame the Mexicans for “taking” American jobs and our unemployment rate is nearly the envy of the industrialized world. 

In fact, however, the subsidies of agriculture, the costly subsidies to favored businesses, such as Airbus, the lack of labor market flexibility, and the high unemployment payments are creating the unemployment problem.  If Turkey is denied EU entrance, then old European capital will go to
Asia. 

If capital flees the host country, does it matter where it goes?  If capital builds up economies within the federation (I know it’s the EU but without a constitution and accountable—meaning elected—officials, the union is little more than our Confederation of States following our Revolution), then markets are near for old industry.  Furthermore, some of that industry may profitably service Eastern Europe but not
Eastern Asia.

To be sure, removing the restrictions that are distorting resource allocations within
Western Europe would be even better.  Labor then could find alternative activities more quickly and new industries could flourish.  Lower product costs would hold down wage growth even as purchasing power improves, just as opening our borders to the world has done for the
U.S. 

Without the stronger bounds of elected officials and constitutional provisions, the united monetary policy will become increasingly at odds with domestic government policies.  High unemployment, high deficits and a monetary system that cannot control asset speculation is inevitable in this environment.  Eventually, such a system will fail. 

In the meantime, watch out for your investments in Western European companies.  Unless they are serving their shareholders by only building new capacity elsewhere, they may no longer be good investments.

In a real estate seminar in January, I stated that housing price increases reflected underlying conditions of reduced costs to finance homes.  For example, about 47 percent of all households nationwide could afford the median home selling nationwide for $190,000. 

To be sure, some pockets of excess exist.  In
San Francisco, only 19 percent of all households can afford the $490,000 needed to buy the median home there.  Arizona, Nevada, the Northeast, Florida and second home havens in the
Appalachians and along the coasts also have homes selling well above household affordable levels. 

Nevertheless, I was not too worried that a housing price bubble would be followed by a housing bust. 

Now, I am certain that a housing bubble has developed that could lead to serious housing price contraction

and possible financial problems in the future.

Certainly, the fact that 66 of the 138 reporting housing markets in the
U.S. experienced double digit price increases in the first quarter contributed to my growing concern.  Discussions with builders who are selling out their condominium projects before the first spade is turned also raised my eyebrows.  Houses that have been sold two or three times before anyone occupied them also could not be ignored. 

Yet, all of these observations also are consistent with a hot housing market that is seeking a higher price point because of increased housing demand.  That more people want more of their assets in housing than in bonds or stocks does not mean, by itself, that a housing bubble exists. 

What has changed my thinking about the housing bubble is the financing of housing that increasingly is happening. 

Economist Hyman Minsky developed a theory of financial instability based upon what he called the “excess gearing” of asset financing.  What he meant is that as asset values increased, lenders became more willing to offer easy terms to finance those assets. 

Remember 1988 when real estate loans increased from 80 percent of asset value to 100 percent and, in some cases, even more than 100 percent.  Those who lived through the subsequent recession certainly remember the aftermath of that “excess gearing.”

Initially, the additional financing adds to the surge in asset values.  The South Sea Bubble, tulip mania, the utility holding company bubble that preceded the stock market crash of 1929 and many more benefited from rising loan to asset values as asset prices soared.  When the asset prices finally stalled (as they must when they become so far out of line with alternative values of wealth), those loans turned sour.  The subsequent collapse exceeded any gains created by the initial surge in asset prices. 

Minsky’s claim that financial markets are inherently unstable has not been established by many other economists, but his theories certainly help to explain the bubbles that have been observed. 

So, is there any evidence that “excess gearing” is happening in the financing of housing?

Can we say “interest only loans” and explain the rising percentage of variable rate mortgages. 

The percentage of new mortgages that are now based upon short term interest rates has tripled in the past two years.  Yet, short term rates have been rising while long term rates have remained relatively stable.  In other words, the “smart” house financing would be to lock in a fixed mortgage rate. 

Are home buyers not being smart?  No.  Lenders are being foolish.  Some lenders believe that rising housing prices will soon justify whatever loan they offer the homebuyer.  If the buyer defaults, the lender will foreclose and sell the appreciated housing asset. 

In isolation, a foreclosed house in a market of appreciating housing values is not a bad loan.  However, if a lot of foreclosures develop, the additional houses sold by lenders will undermine values.  A lot of home loans then will go bad very quickly. 

So why are homebuyers taking the interest only loans and the variable rate mortgages?  The lenders are qualifying the homebuyer based upon the buyer’s ability to service loans in the short run.  Variable rates remain lower than fixed rates, if only barely.  Interest only loans use even less of the monthly paycheck at the beginning of the loan than traditional loans. 

Low initial monthly payments allow buyers to purchase those inflated houses.  But short term rates probably will continue rising.  Soon, buyers will not be able to purchase the median home even with the variable rate mortgage or the interest only loan. 

I do not know when lenders will begin reducing the number of households qualifying for the median priced home, but it will be soon.  And we know from past experience that the impact of the subsequent price collapse will be financial as well as in the housing market. 

 A good economic forecaster needs to tell a story that makes sense.  We do not need to be Brothers Grimm or even Mark Twain, but we must be believable and consistent with economic theory. 

Of the two recent stories about oil prices, Goldman’s prediction of price spikes to more than $100 per barrel is possible, but Merrill’s over $50 for as far as the eye can see is not.  However, my story is different from either of those. 

The economic theory that needs to be addressed is price elasticity.  This describes what percentage change in quantity will occur for any given percentage change in price for any good and service.  Actually, the observed price is the result of interactions of both demand and supply conditions, so both demand and supply elasticities must be considered. 

The story that makes $100 price spikes possible is similar to the following:  Some supply shock could push up oil prices.  These price increases, in turn, lead speculators to believe the demand for oil is increasing (which is wrong, but such beliefs certainly are possible).  They, therefore, accumulate speculative holdings of inventory to profit from rising prices. 

At the same time, consumers believe oil product prices are going through the roof.  Therefore, they keep their heating oil tanks full and top off the gas tanks of all their cars.  Until this process is completed, it appears as if a surge in demand for oil has occurred.  Thus, prices surge. 

However, prices cannot stay up.  Once the tanks are full, demand tapers off.  Furthermore, higher prices lead to economic changes.  More miles may be driven with the more fuel efficient vehicles.  Thermostats may be adjusted.  The larger purchasing power left at the gasoline station (and transferred to suppliers who are mostly abroad) will not be spent elsewhere. 

Those unpurchased goods accumulate on shelves.  Production is cut.  Jobs are lost.  And the number of people needing to drive to work are reduced.  Over time, more fuel efficient cars are purchased and people adjust their distance to work by changing jobs or homes.  Thus, the spiking prices soon fall back.

Actually, the $100 story is not that believable.  To get a supply disruption to double oil prices, supply elasticities indicate the shortfall from trend growth must be more than 15 percent in the short run, and substantially more over time.  Nevertheless, a speculative inventory surge coupled with tank topping could create a temporary price spike.

The problem with Merrill’s forecast is that they fail to realize that quantities demanded tend to fall over time for any given price rise.  That is why the oil price surge of 1973 was followed by years of downward drifting prices.  The surge in 1981 was followed by the oil price plunge of 1986. 

The last time I estimated the responsiveness of oil quantities demanded to price changes, I measured a short run responsiveness of 0.2 but a longer term change of 0.7.  Thus, the highest prices occur near the first price peak, and then prices drift downward until trend changes in quantities demanded and supplied finally become consistent with what the long term price elasticities are generating. 

In the past two years, oil prices have virtually doubled.  To sustain that level, we probably need to increase quantities demanded because of economic growth by almost 30 percent  worldwide or remove almost 25 percent from quantities supplied.  Those who are waiting for refinery capacity to fail would need to see about 10 refineries shut down simultaneously.

Moreover, too much has been made about no refineries being built since 1978.  In the first quarter, refineries were operating at 90 percent of capacity, down from 91.3 percent during the fall.  As any refiner will explain, there are ways to increase production from existing refineries without seeking the environmental permissions to build new ones. 

To be sure, we would have more productive refineries if we could build state of the art units; but environmental realities probably make such construction unlikely. 

So why are we inventing stories that deny the responsiveness of supply and demand conditions in the oil markets to changes in prices?  Could it be that hedge funds have over-committed their resources to oil and Wall Street is worried that brokerage firms will lose if hedge funds do not make good on their bets? 

Whatever the reasons, let us get forecasting stories that recognize the elasticities of demand and supply in the petroleum markets.  (I still believe oil prices per barrel will be in the low $40s before the end of summer). 

An old adage on Wall Street is three rate increases and you’re out.  If the Federal Reserve shifts toward restraint, stock values cannot perform well.  Three rate increases clearly reflect a policy shift.  Therefore, look out for the next bear market when the Federal Reserve restrains money growth. 

However, there is an exception to this adage.  If the Federal Reserve had been expansive in order to jar an economy out of lethargy and the Fed now is withdrawing that thrust, stock prices can continue to improve.  In a perfect world, investors would applaud this maneuver to sustain growth for an extended period of time. 

Of course, the world is not perfect.  Indeed, the current Federal Reserve’s strategy is flowed.  A measured removal of a subsidy could mean that the Fed is providing the least monetary thrust after the economy already has slowed to less than sustainable growth.  As no new tax initiatives are planned, we might have tightening monetary and budgetary policy during a period of slowing growth. 

Because of this apparent policy failure that may be brewing, I must consider the recession of late 2006, which will be anticipated by the stock market sometime in 2005. 

Nevertheless, quick action to remove the unsustainable monetary thrust still might prove timely, as it ultimately did in 1994.  Indeed, I would currently suggest that the odds are about even that we get it right and maintain sustained economic growth through the remainder of this decade. 

Let’s assume that is the case. 

Then we do not want to dump most of our stocks.  To be sure, the homebuilders, mortgage refinancers, home remodeling stores, some of the furniture and appliance companies and stores, and even the landscapers and housing related activity may be overdone.  A price pullback in those stocks could develop. 

However, investors sometimes believe that higher interest rates only compete with interest related stocks.  Thus, the high dividend stocks are seen as vulnerable.  Also, the utilities and financial institutions, which continuously pay relatively high dividend yields are under the gun.  REITs look especially vulnerable as an alternative to bank yields. 

Indeed, all of these issues fell sharply in 1994.  And then rallied in the next few years.  The smaller capitalized stocks that did not pay dividends performed well in 1994 and then lagged for much of the remainder of the decade. 

These patterns developed because the first assumptions about losing competitiveness to bank rates as interest rates rise is only a very small part of the equity issue.  If occupancy rates and rental rates are rising, then the cash flow of REITs is improving.  Not only can their payouts grow along with bank rates, but the value of their assets can continue to rise. 

If we achieve sustained growth, then many smaller companies can grow while risky credits can become well.  The next surge of segment growth could spurt in the latter part of this decade (although I am not smart enough to know what that segment is—perhaps pharmacological). 

Although investors are selling off all finance related companies, that is too simplistic.  To be sure, banks and finance companies that relied heavily upon mortgage refinancing will have some difficulties.  But many banks earn more on enterprise loans and mortgage and acquisition loans than they do on refinancing fees.  The latter will intensify.  Also, community banks will find at least a little rate increase a benefit in beginning to compete for bank deposits again.  The rates were so low that they could not pay the administrative and advertising costs to seek out deposits. 

As for insurance companies, the issue is in the risks.  If no unexpected risks surface, such as the twin towers disaster, then their premiums should cover their losses.  Then higher interest rates actually increase returns on their investments, raising the value of their enterprises. 

In a nutshell, some entities have benefited from low interest rates.  They will not do well as rates rise toward more normal levels.  However, good policy is to avoid the surge and sag economy that almost certainly will develop if rates remain at unusually low levels. 

Already, hedge funds are heavily into exploiting the “carry” (the gap between short term and long term rates).  This is possible because the gap is artificial.  If we are to avoid another Long Term Capital Management type scare, we need to remove these artificial conditions.  That is how we can get sustained growth. 

Frankly, I am seeing the current market stall as an opportunity to position my portfolio for sustained growth.  But, I wish the Fed would remove “measured” and replace it with “deliberate” in its actions as I also search for evidence that the 2006 recession is becoming more likely.